The chancellor’s headroom against Labour’s fiscal rules could be almost halved at his first budget if the current global bond sell-off persists into the autumn, economists say.
The UK’s long-term borrowing costs jumped to their highest level since early 1998 on Tuesday as investors dumped government bonds, betting on higher inflation.
The yield – in effect the interest rate – on 30-year UK government bonds, known as gilts, hit 5.89% at one point as London markets caught up with a sell-off that swept Japan and the US on Monday, a bank holiday in the UK.
Ten-year gilt yields were around 5.25%, their highest level since the 2008 global financial crisis.
Higher yields progressively increase the cost of financing the government’s debt. If sustained, these would pass through to the Office for Budget Responsibility (OBR)’s forecasts for John Healey’s 28 October budget.
Deutsche Bank’s chief UK economist, Sanjay Raja, said that based on Tuesday’s yields, Healey’s headroom against the current budget rule would fall from £26bn at Rachel Reeves’s spring forecast to £13.8bn before covering any additional spending plans.
Almost all of the deterioration results from higher government interest costs. The OBR’s March forecast had gilt yields at 5.1% for this year. Gilt yields eased back a bit later on Tuesday – to 5.85% for the 30-year and 5.21% for the 10-year – but they are still well above the predicted level.
Raja suggested Healey would be likely to try to maintain headroom of at least £10bn to assuage market concerns about the government’s commitment to balancing the books. “£10bn to me is the floor. In a perfect world you would want to keep 15,” he said.
In addition to global forces, Raja said higher-than-expected growth in the UK in the first half of the year had also contributed to rising yields. “There are some good reasons,” he said.
The current budget rule is the promise that the government will match day-to-day spending with receipts and only borrow for longer-term projects.
Tuesday’s market moves underline the tricky global backdrop facing Andy Burnham’s government as he returns to Westminster promising to help consumers with the cost of living.
The OBR takes market expectations of future gilt yields during a two-week reference period in to account in its forecasts. It does not announce these dates in advance, but Raja suggested judging by the timing in previous years, the current tumultuous period may be included in its budget projections.
The bond sell-off was driven primarily by international factors. Japanese 10-year yields hit their highest level since the 1990s over expectations that the Bank of Japan would have to raise interest rates to control inflation.
Investors also appeared to be responding partly to higher oil prices, which were up 1.7% at $92 after a fresh exchange of fire between the US and Iran over the weekend. Higher energy costs drive up inflation, potentially forcing central banks to respond.
As well as fretting about future price rises, bond investors also appear to be concerned about runaway deficits in the US, where the Trump administration has cut taxes and is having to hand back much of the revenue from swingeing trade tariffs.
The chief economist at the consultancy Capital Economics, Neil Shearing, said: “It’s been a perfect storm for the bond markets: we’ve had these fiscal concerns that have pushed up the long end of the curve, and now that’s being compounded by upward energy price pressure, pushing up interest rate expectations in the short term – and if you’re sitting in the Treasury, none of that is good news.”
Finance ministers and central bankers from the G20 major economies concluded their meeting in North Carolina to discuss the state of the global economy on Tuesday.
The US and Japan took the rare step of intervening jointly in global foreign exchange markets in August in an attempt to prop up the yen, but the Japanese currency subsequently resumed its slide.
Expectations of higher interest rates were also piqued by a speech on Friday by the Federal Reserve chair, Kevin Warsh, in which he said the US central bank would still have “work to do” if inflation did not return to target.
Before Warsh’s intervention, markets were betting on about a one-third probability of an increase in US rates in September, but that has risen to 70%.
